Planning for Highly Appreciated Assets

When you acquire property (real estate, investments, etc.), what you pay for property you acquire is known as your “cost basis” or investment in the property. It is this number that becomes important when you determine the tax on any gain, when the property is sold. The basis rules become very important in estate planning. Here’s why: If someone gives you property, you get that person’s basis in the property, which is known as a “carry over basis.”

But if you inherit property, you get a basis equal to the property’s fair market value on the date of death. If you have substantially appreciated property, it may be better to hold it, rather than give it to your heirs, to take advantage of these basis rules. Here’s an example of why: Example: Dad purchases a home for $30,000 in 1980. This is what’s known as his “cost basis.” He puts in a new kitchen for $20,000 and increases his basis to $50,000. If Dad makes a gift of house to Son, when it is worth $500,000, Son gets his Dad’s basis of $50,000. If Son sells the house for $500,000, Son has a gain of $450,000.

If Dad doesn’t give Son the property now and instead Son inherits it when Dad dies, Son does not get his Dad’s $50,000 basis in the property. Instead he gets a basis equal to the property’s fair market value when his Dad dies. If the property is worth $500,000 and Son sells it for $500,000, he pays no tax on the built in gain! In 2014, if Dad had made a gift of the property to Son and Son sold the property for $500,000, Son would pay $67,500, in taxes at capital gains rates, which is better than the $157,500 which would be due at regular tax rates. However the $67,500 could be saved if Dad held the property or put it in a special trust for Son, and Son waits til after Dad dies to sell.

HOW GAIN IS TAXED

Gain on property held as an investment is typically taxed at lower (more favorable rates) than regular income tax rates. Under present law (2014):

It is taxed at 15% if your taxable income is below $457,600

It is taxed at 20% if your taxable income is higher.

Regular income tax rates are much higher: 39.6% if your taxable income is higher than $457,600 or 35% if it is less than that threshold. [This is federal tax and does not factor in NYS income tax.]

VALUE IN HOLDING HIGHLY APPRECIATED ASSETS

This tax play can prove to be of great tax savings for those who own low basis property. For example, in Westchester County, if you bought your home 40 years ago, you could have a $30,000 basis in a home now worth close to a million. The income tax savings on $900,000 of built in gain is about $120,000! This is also a valuable planning tool when there is a family business or substantially appreciated property. For example, let’s say Dad owns a business worth $10 million, with a $1 million basis. If Dad gifts the property to Son and Son sells it for $10 million, Son will pay tax of $1.8 million (even at low 20% capital gains rates.) If instead Son inherits and then sells the business for $10 million, he will pay no income tax on the gain.

ESTATE TAXES

Note that these are income tax rules and have no effect on whether the asset will be subject to estate tax. With the hefty federal tax exemption ($5.34 million per person), most people will not owe federal estate tax in 2014. New York estate tax (which tops out at 15%) kicks in on estates above $1.1 million. Both systems provide there is no estate tax on spousal transfers.